Having been one of the few ports in the storm of 2022, it has been a dismal start to the year for infrastructure trusts. Every fund across the three main infrastructure sectors – infrastructure, infrastructure securities and renewable energy infrastructure – is down in share price terms for the year to date. For some of the renewable energy trusts, seen as vulnerable to falling energy prices, those drops have been particularly painful.
NAVs resilient, discount widening the problem
The problem has not been NAV performance, which has ticked higher for the majority of trusts. The NAV for JLEN Environmental Assets (JLEN), for example, is up 4.4% over the last 12 months, Greencoat UK Wind has seen the value of its assets rise 7.5%, while GCP Infrastructure Investments (GCP) has seen a 2.8% rise. Yet over the same period, their share prices are down 7.4%, 13.7% and 21.1% respectively.
The real culprit has been discounts, which have spiked out significantly and now look extreme relative to history. JLEN’s discount sits at around 15%, having traded at an average of 2.7% over the past year. For Greencoat UK Wind, the discount is 17% against an average of 3.9%. 3i Infrastructure – the best performing trust in share price terms – has moved from an average premium of 0.2% to a discount of 7.4%.
Share price falls look overdone
The share prices now imply a significant derating in the future value of the assets or cashflows. Yet it is difficult to see where this would come from. Certainly, there may be some impact to the NAV from higher interest rates, with a higher discount rate applied to cashflows. But, for the most part, infrastructure assets have inflation-linked cash flows. The inflation protection should raise not only the level of current cash flows, but also future cash flows, which should compensate, to some extent, for a higher discount rate.
Equally, there may be some impairment for the energy-focused trusts, which are vulnerable to energy prices. These have fallen significantly in recent months. Nevertheless, prices are still high by historic standards and many trusts have fixed price contracts in place. On a straightforward appraisal of the sectors’ prospects and cash flows, the falls in share prices look overdone.
With rising interest rates, investors have more choice
Chris Morgan, investment director at Amber Infrastructure, which managers the INPP trust, suggests a more straightforward explanation for the current weakness in share prices: “We hold around 140 different assets, which continue to perform well from an operational and financial perspective. I suspect what has driven the recent falls is the macro and geopolitical situation. Interest rates have risen and investors are looking at fixed income and relative valuations.”
Infrastructure has been a major beneficiary of the low interest rate environment, providing one of the few places to get inflation-adjusted income at a time when interest rates were very low. Now investors have more choice. In June, the UK government issued a two-year bond at a yield of 5.668%[1], the highest yield since 2007. While this does not provide inflation protection, for many investors it is perceived as a less complex option than infrastructure. The latest IA statistics show retail investors directed inflows of £632m to bond funds in May, with Government Bonds the top selling sector[2].
The question for investors today is whether it is worth taking advantage of these historically wide discounts to buy into a sector that has historically traded at or near NAV, or whether selling pressure will continue. Certainly, dividend yields still look attractive, with 25 out of the 31 funds across the three infrastructure sectors trading at a dividend yield of 5% or higher. For most trusts, this comes with some inflation protection.
Strong inflation linkage
Morgan says the inflation linkage will not be an exact match to CPI, but is usually contract-based: “The vast majority of our portfolio is in PPP or regulated assets. Underpinning those are project agreements or licenses that explicitly stipulate how revenues will be adjusted each year to reflect prevailing inflation. Some may pick up once a year, or use a different index, but the key point is that the inflation linkage is clearly set out in the contracts.”
Richard Sem, a partner at Pantheon’s Global Infrastructure team, which manages Pantheon Global Infrastructure (PINT), points out that while operating costs may also rise, there tends to be a positive spread. “As inflation increases, that gap increases.”
Could there be an imminent valuation shock, with infrastructure assets subject to selling pressure as institutional investors re-focus on fixed income assets? While it will depend on the individual infrastructure asset, Sem says, there is little to suggest it: “We expect the valuation environment to be relatively benign, given the store of value they can provide in inflationary times.”
More breadth than ever
Phil Kent, director at Gravis Capital and portfolio manager for GCP, says there has been some over-crowding in certain sectors, which has pushed up valuations. If those investors move out in favour of opportunities elsewhere, that could be some vulnerability. “Infrastructure has significantly evolved as a sector and there is a lot more capital chasing a more limited pool of assets, particularly in the core, core-plus areas.”
However, the infrastructure sector offers more breadth than it ever has before. Sem says: “There are traditional energy and utilities, transportation and logistics infrastructure – infrastructure 1.01. These are the staple of infrastructure funds. But there are also digital assets. This is a ‘new utility’. This includes mobile towers, fibre optic cables, data centres. There is also everything to do with the energy transition – including areas such as hydrogen.” Against this backdrop, analysing infrastructure has become more complex, but it also offers a broader range of risk/reward profiles.
At Gravis Capital, they try to avoid any over-crowding problem by investing early in newer areas – it was a relatively early investor in wind, solar and anaerobic digestion, for example. However, recent investments include financing a fleet of electric-powered London taxis and a geothermal plant at the Eden project in Cornwall. Kent adds: “Going in with debt rather than equity helps manage the risks. We always target assets with some form of public sector-backed revenue stream, such as a government subsidiary, unitary charge under a PFI contract or a renewable subsidy, or housing benefit.”
Certainty and stability – doing what it does
Ultimately, even in the ‘newer’ parts of the infrastructure market, the nature of this type of asset is stability. Kent says: “Infrastructure should be characterised by certainty over cash flows or underpinned by contracts or monopoly or monopoly-like characteristics that has high barriers to entry.”
Infrastructure has struggled less because of its fundamental characteristics than the environment around it. It continues to do what it does, delivering an inflation-adjusted yield and steady growth in asset values, but the value of these returns to investors has changed over time. It has been a victim of new-found range of income options for investors, but its outlook remains unchanged.
[1] https://www.reuters.com/markets/rates-bonds/uk-sells-government-bond-with-highest-yield-since-1999-2023-07-05/
[2] https://www.theia.org/news/press-releases/may-sees-modest-inflows-bond-funds-leading-way